Sovereigns

As Industrial Production falls -0.6% in Europe and as the economy shrinks -0.2% there is once again a good reason to pause to consider the ramifications for this going forward. When you sit back and take a hard look at the last two years you begin to learn a few things. If you just stick to the actual data and forget the rhetoric that surrounds it the picture becomes clearer. Each and every projection for Greece, Spain and Italy that has been forecast by the EU and the IMF has been wrong; dead wrong. Europe is getting worse and not better. Whether you turn your attention to Greece, Spain, Italy, Portugal or even Ireland; it is getting worse. Nowhere on the Continent are things improving and even in France and Germany the financial strains are beginning to show. It is not a question of Euro-bear or Euro-bull; it is just the numbers as they come rolling out month after month. It is the banks, it is the sovereigns and grand visions must, in the end, give way to the facts.

A week ago we explained quite clearly why instead of encouraging self-defeating, short-termist behavior by promising to save Europe's insolvent countries if and when needed, which does nothing to resolves Europe's problems and make it worse in exchange for a brief respite from bond selling, the ECB should be doing precisely the opposite: encouraging local governments to understand that there is no magic bazooka from the central banks. Specifically we said that "this Catch 22 of confounding cause and event can continue seemingly indefinitely, although in reality it can't. Because fundamentally what the bond market does is keep sovereigns "honest" - just as Schauble said a week ago, Spanish yields at 7% are not the end of the world - instead what they are is a signal to the country to get its spending in control in order to reduce its deficit, and fundamentally get its house in order - yes, that means getting government spending to a sustainable level and firing hundreds of thousands of workers, as well as probably raising taxes even more. It also means pain all around, but the pain is inevitable and will only be worse the longer reality is denied." This logic is so clear that only a lifelong economist, PhD or Goldman apparatchik can not grasp it: sadly that accounts for most of the people "in charge." Which is why we were delighted to read that at least one person "gets it" - Belgian national bank governor Luc Coene, the same Belgium that is also the heart of the bureaucratic labyrinth known as the EU, who told Belgium's two largest newspaper that "buying the bonds of these countries would only serve to weaken the ECB and do nothing to resolve underlying issues of competitiveness.  “It makes no sense for the ECB to start financing those countries,” said Mr Coene, “It would only lead to the ECB taking on the whole public debt of Spain and Italy onto its balance sheet." Bingo. And not a moment too soon - we really were starting to pull a Mogatu here.

Every now and then we prefer to sit back and let some of the smartest money speak, especially when said smart money agrees with us. In this case, we hand the podium over to none other than Paul Singer's Elliott Management, which after starting with $1.3 million in 1977 was at $19.8 billion most recently. No expert networks, no high frequency trading, no "information arbitrage", no crony capitalism and pseudo monopolies of scale, and most certainly no bailouts: Singer did it all the old fashioned way: by picking undervalued assets and watching them appreciate. The timing is opportune because while Elliott has much to say about virtually everything in their latest 20 pages Q2 letter, it is the billionaire's sentiment vis-a-vis US Treasury debt that may be most critical, and may be the catalyst that resulted in today's abysmal 10 Year bond auction. To wit: "long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward." There is little that can be misinterpreted in the bolded statement. And while many have taken the other side of the Fed over the past 3 years, few have dared to stand against Paul Singer because if there is one person whose opinion matters above most, certainly above that of the Chairsatan, it is his.

Since the European Summit a mere six weeks ago, Crude oil prices have surged over 20%. It seems, if one looks at stock prices, that between Monti's 'bluff', Rajoy's 'threats', and Draghi's 'promise' that everything has been fixed in Europe and all-is-well in the world as Europe's stocks swing to a year-to-date gain of 5% (with Spain and Italy up 10-15% since the summit alone). However, if one considers for one moment what exactly they are supposed to have 'fixed' then it seems one of these markets is not like the others... 10Y Spanish spreads are 10bps wider than pre-summit, Italian 10Y is only 10bps tighter, Portugal 10Y is unchanged and the Bund has outperformed Treasuries by 15bps. European corporate and financial credit has rallied but has dramatically underperformed - especially post-Draghi - as it is clear that investor hope for more unsterilized Fed/ECB 'aid' is more than priced into equity markets and has had the aforementioned unintended consequence of spilling out into energy markets - with all the negative feedback implications that come with that.

It's happening again. The euphoria is fading in the critical fulcrum security markets but stocks remain oblivious in their momentum-heavy liquidity-less way. Spanish and Italian sovereign bonds ended weaker - quite notably weaker in the case of Spain with the curve flattening significantly as the much-heralded front-end started to give some back and 10Y spain leaked back up towards 7% yields. Compared to post Draghi-'believe' (and post-Draghi 'reality') the Spanish and Italian stock markets are cock-a-hoop - massively outperforming. European equity markets in general are now the Usain Bolt compared with the Derek Redmond of European credit markets as once again stock holders are either last to get the joke or first to be ignorant enough to play the ECB's game of chicken. Spain's IBEX is now +13% from Thursday's close, followed by Italy +10% - but Italy and Spain 10Y bonds are still wide of the pre-Draghi 'reality' trough in spreads. German and Swiss rates increased modestly today but the latter remains negative out to 6Y.

To be correct, it is a series of games of chicken, as next to the different sovereigns, the ESM/ESFS, the ECB, and why not the IMF, below the sovereigns there are the regions, be it in Spain or, as it stands, in Germany.

"Who knew that the 24th electoral district in Chicago actually sits in Northwest Madrid?" That is how Art Cashin concludes his tangent into the president's pre-election tactics, which now apparently involve begging heads of sovereigns to accept bailouts from other sovereigns (coughgermanycough) just to boost one's reelection chances. Why? Because the one thing that could send the S&P ripping higher, however briefly, is what we have been discussing for the past week: namely the market finally getting the paradoxical catalyst that the market has already priced in - Spain admitting it is broke. And why would Obama be focused on a rising S&P, fiscal cliff after the election notwithstanding? The chart below should explain it.

Never forget; there are two sides to the European fiscal proposition. There are the funding nations and the borrowing nations and I suggest that the focus of the markets will soon turn to the funding countries and their capacity to provide capital without endangering themselves. I think the attention of the markets is about to turn to Germany and France, the largest components of the European Union, and with GDP’s of $3.2 trillion and $2.77 trillion respectively the question is going to come around to just how much these two countries can support without sending themselves into a serious economic quagmire. The EU officially recognized sovereign debt of Greece is now 22.33% of the GDP of Germany and 25.80% of the GDP of France. The banks in Europe dwarf the sovereigns with balance sheets three times larger than of all of the EU nations and with Spain having now fallen and Italy about to go; just how much that can be afforded is quickly coming into the focus of many money managers.

There has been much confusion over last week's remarks by Mario Draghi, with the prevailing narrative being that the market first got what Draghi meant wrong (when it plunged), then right (when it soared). The confusion is further granulated by attempts to explain what was merely a desperate attempt at delaying a decision for action, which was inevitable considering the now open opposition by Buba's Weidmann, into a formal and planned plotline: "Inverse Twist" or other such technical jargon is what we have seen floating around. The reality is that, just like all other central bankers, Draghi did what he does best: use big words and threats of action in hope it will buy him a few extra days of time. The reality is also that, just like when the LTRO was announced, the market did get it right initially, when peripheral bonds plunged, and got it wrong over the subsequent 3 months when bond prices rose, only to collapse to new lows (and in the case of Spain - record high yields as of two weeks ago). Back then, the ECB merely bought a few months time with its transitory intervention. This time it has at best bought a few days with the lack of any actual action. And yet, Draghi did leave a way out, for at least another brief respite (where unless Europe expands the available bailout machinery yet again, the respite will have an even briefer half life than that from the LTROs). The way out is simple, and in order to avoid any confusion, we will use an allegory from the movie Batman: Spain and Italy can be saved. But first they must be destroyed.

For months the European Union, the IMF and the European Central Bank focused all of their attention on the giant firewall that was supposed to protect the core countries of Europe. It was all a diversion and one that, once again, did not work. I think the real problem is that the European Union has come to believe their own concocted nonsense. I think they honestly believe that it is some band of speculators, some Jesse James type of gang riding out of the American West that is trying to drive up European interest rates and destroy their beloved construct. The bonds of Germany, France, the Netherlands et al now trade at negative levels in the short end; this is not that the credits are so great it is that a lot of European money is mandated to stay in Europe so that the money has been put in the safest places available within the mandate and hence negative yields. Germany is becoming troubled economically and will be in a recession along with the rest of Europe by the fourth quarter of this year.  We suspect both the ECB and Fed will disappoint as the expectations, especially for the ECB, to provide some kind of miracle will not be the manifest destiny hoped for by many.

The catalyst for the major turnaround in markets last week was comments from ECB President Draghi that he was prepared to do whatever it takes to preserve the Euro and ensure monetary policy transmission. While this is nothing more than stating his mandate (and that water is wet), the focus on 'transmission' caught the attention of many and Barclays provides a succinct flowchart of just where those transmission channels are broken. However, with SMP empirically a losing proposition for sovereign spreads, LTROs having had no impact on loans to non-financial corporates, and rate cuts not reaching the peripheral economies (and in fact signaling further divergence); it seems that short of full-scale LSAP (which JPM thinks will need to be a minimum EUR600bn to be in any way effective), whatever Draghi says will be a disappointment and perhaps that explains the weakness in European sovereigns this week as exuberance fades (or is the game to implicitly weaken the EUR to regain competitiveness).

It would be odd to suggest that one of the most scathing critiques of the ECB's attempts to talk up the market on nothing but hope, promises and expectations would come from rating agency Moody's, yet that is precisely what has happened. With Swiss, Dutch, Finnish, and German short-dated bonds once again hitting new record low (negative) rates (and Italian 10Y is weakening), it would appear that at least some of the market is not drinking the all-things-risk kool-aid.

Pushing them to build up more debt to push additional debt on over-indebted nations who clearly can't pay back their current debt is quite foolish. Recession and depression looms everywhere.

Goldman's ex-employee Mario Draghi is in a box: he knows he has to do something, but he also knows his options are very limited politically and financially. Yet he has no choice but to escalate and must surprise markets with a forceful intervention as per his words last week or else. What does that leave him? Well, according to Goldman's Huw Pill, nothing short of pulling a BOJ and announcing on Thursday that he will proceed with monetization of private assets, an event which so far only the Bank of Japan has publicly engaged in, and one which will confirm the world's relentless Japanization. From Pill: "Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed." Why would the ECB do this: "A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations." In other words, the only thing better than a little global central banker put is a whole lot global central banker put, and when every central planner is now all in, there is no longer any downside to putting in even more taxpayer risk on the table. Or so the thinking goes.

The Europeans have played the Great Game badly; are playing it badly and there will be consequences for their failures. All of this nonsense with Greece, with Spain, could have been avoided by telling the truth about the numbers, by not goose stepping with plans meant to mislead instead of illuminating the truth, with trying to hide the self-evident and presenting scams as solutions or by addressing the size of firewalls instead of trying to cure the sickness of the nations that lie within them. There is no Prince, there are no glass slippers and the bills have to be paid and the money to pay them will not be found in the pot of gold at the end of some rainbow. Unless the Germans are willing to have the same standard of living as those in Greece and that will not be happening so that it can be foretold that the play will end badly. It is not economics that will determine the end of the European fantasy but politics.